401(k): To convert, or not to convert, that is the question

[jnojr]

I'm 40 and in the highest tax bracket. Not rich (it's more likely that I'll wind up in the $250K area). I have a 401(k) from my last employer, and in the past I pretty reflexively dumped old 401(k)s into my Roth IRA and took the up-front tax hit. This one's a little bigger (about 50% of my IRA), and I'm just looking for some more input before I decide what to do with it.

The 401(k) is with Principal, and I'm actually fairly happy with the funds I'm in, given what's available. I could leave it as-is. I could convert to a traditional IRA with them, and maybe switch up the funds a little. I could convert to a Roth with them. Or I could convert to either IRA with my primary institution USAA.

I'm aware of at least some of the issues with Roth vs. traditional... if I convert now, I'm taxed at the highest rate, when theoretically I'd be in a lower bracket in retirement. But getting the gains tax-free is great, unless they decide to tax Roth gains, which isn't impossible. Nor is it impossible that they'll just try to raise taxes on everyone. I'm more in the Roth school myself, but who knows? That's why I'm looking for more perspective

 

[kaneohe]

I'm ................. in the highest tax bracket.

I'm aware of at least some of the issues with Roth vs. traditional... if I convert now, I'm taxed at the highest rate, when theoretically I'd be in a lower bracket in retirement. But getting the gains tax-free is great,..........................

The real world situation of what might/might not happen is quite complex and not predictable w/ certainty as you point out. Perhaps you should first unravel this simple problem. Have you done any real mathematical calculations of the problem above? Convert at the highest tax bracket and withdraw at a lower bracket later vs. convert at a lower tax bracket later? Yes, getting gains tax-free is great but at what price. In the end, this is a math issue not a conceptual one.

 

[misty57]

We decided to wait to convert until after retirement. Although we have taxable accounts, we have no Roth; so we will do an annual 401k rollover to a TIRA and then convert that to a Roth based on income (mostly pension), deductions/exemptions, and ceiling on tax brackets. We will delay SS as long as possible to keep our taxable income at a minimum, probably until age 70. We will have 14 years to do the conversions. The question for us will be whether to try to stay in the 15% tax bracket, which will reduce the amount that is converted or to go for it and jump into the 25% tax bracket assuming that taxes will be increased in the future.

We have between $1-2M in our 401k and do not want to get creamed by RMDs.

 

[Alan]

I would roll it over to a tIRA. No point in paying high taxes now. The tIRA will give you all the fund choices you need and no taxes payable while you are in a high tax bracket.

 

[pb4uski]

I would roll it over to a tIRA. No point in paying high taxes now. The tIRA will give you all the fund choices you need and no taxes payable while you are in a high tax bracket.

+1

I don't think it would be wise to convert while you are in a high tax bracket even though future gains would be not taxable. This assumes that you would be in a lower tax bracket in retirement.

I was in the 28% bracket my last year of work and expect to do a significant tIRA>RothIRA conversion later this year and pay less than 10%.

 

[growing_older]

You might want to consider the backdoor Roth. As a high income earner, you do not qualify for a direct Roth contribution each year, but you can contribute to a non-deductible traditional IRA. Then later convert that to a Roth. The tax due calculation is based on how much pre-tax and how much post-tax money you have in all T-IRA combined. So if this 401k money would infuse a lot of pre-tax money into your T-IRA it could affect your ability to backdoor to a Roth in the future.

If you already have a lot of pre-tax money in T-IRA, then I would move out of the 401k to get away from expensive Principal funds.

 

[GrayHare]

To my knowledge, in some states a 401k is better protected from creditors than is an IRA. Some employers offer a Roth 401k, which is a way to get the funds into Roth format without having to use an IRA.

For most in a high tax bracket, it is better to postpone conversion from traditional to Roth. Situations in which you should convert anyhow include: 1) if you won't be in a lower bracket in future years, 2) if you expect your investments to significantly increase in value, and 3) if special tax breaks exist on conversions, such as happened in 2010.

For example, though it put me in a high bracket, I converted to Roth in bulk about 2 years ago. Since then the IRA has gained more than the tax due, and per the 2010 conversion rules I've not yet paid any conversion tax at all. Those payments deferred into 2012 and 2013, by which time nontaxable dividends will have compounded even further.

 

[TromboneAl]

1. Is this an all or none thing?

2. Have used an online Roth conversion calculator?

 

[kaneohe]

For most in a high tax bracket, it is better to postpone conversion from traditional to Roth. Situations in which you should convert anyhow include: 1) if you won't be in a lower bracket in future years, 2) if you expect your investments to significantly increase in value, and 3) if special tax breaks exist on conversions, such as happened in 2010.

.

GrayHare.......it's not clear to me if you are saying:
A) you should convert anyhow if conditions 1) AND 2) AND 3) exist

OR

B) you should convert anyhow if
condition 1) exists
OR
condition 2) exists
OR
condition 3) exists

In other words, an AND gate or an OR gate?

 

[Bogie]

Here's a little algebra to demonstrate that it doesn't matter whether you contribute to a Traditional IRA or a ROTH IRA. (If the tax rate is the same before and after retirement and the investments give the same returns). The left side assumes you put the money in pre-tax then earn a return on the investment over "n" number of years and pay tax when it is withdrawn. The right side assumes the money is taxed and then invested and earns a return over "n" number of years. If you love algebra as I do you can see that the left and right sides of the equation are equal if the tax rate is the same before and after retirement. For most people the tax rate is lower in retirement so it's actually better to invest in a traditional IRA and convert to ROTH after retirement when tax rates are presumably less.

Traditional IRA = RothIRA
------------------------------------------------------------
(Money(1+i)^n)*(1-taxrate) = (Money)*(1-taxrate)*(1+i)^n
You can swap the last two terms because it doesn't matter the order because of the commutative property. So, then the left side of the equation is exactly the same as the right side of the equation.
(Money(1+i)^n)*(1-taxrate) = (Money)*(1+i)^n)*(1-taxrate)

 

[GrayHare]

In other words, an AND gate or an OR gate?

Language vs. Logic is a reason courts exist. You are correct, it was not clear. I meant OR, so if any of those conditions are met, the Roth conversion should pop up on one's radar. Usual disclaimers apply.

 

[GrayHare]

Bogie - if only the equation were that simple for all. Your example does not take into account the tax deductibility of a tIRA contrib. This came up a few months back: if the tIRA contrib is not deductible, and one pays the same tax rate before and after retirement, the Roth comes out far ahead due to its tax-free compounding.

 

[kaneohe]

Language vs. Logic is a reason courts exist. You are correct, it was not clear. I meant OR, so if any of those conditions are met, the Roth conversion should pop up on one's radar. Usual disclaimers apply.

ok, I'll bite....leaving aside the question of how you know what your investment will do in the future (your crystal may work better than mine )
Suppose you expect a 100X increase in your investment but you convert at
a higher rate now than in retirement. Can you give an example of how the
Roth works out better?

 

[GrayHare]

ok, I'll bite....leaving aside the question of how you know what your investment will do in the future (your crystal may work better than mine )
Suppose you expect a 100X increase in your investment but you convert at
a higher rate now than in retirement. Can you give an example of how the
Roth works out better?

If my tIRA value jumped by 100x, so would its taxable RMDs, which would by themselves put me in a higher tax bracket during retirement.

 

[kaneohe]

OK, I got carried away by my 100X increase.....revise to some large increase but not enough to make later bracket higher than conversion rate.
I guess I am thinking that the relative tax rates: conversion vs. withdrawal are still the largest factor in the conversion decision.

 

[kaneohe]

Bogie - if only the equation were that simple for all. Your example does not take into account the tax deductibility of a tIRA contrib. This came up a few months back: if the tIRA contrib is not deductible, and one pays the same tax rate before and after retirement, the Roth comes out far ahead due to its tax-free compounding.

It also assumes that due to limited funds, the full allowable Roth contribution is not made. If the full Roth contribution is made because the tax is paid by available other funds, the Roth is ahead , even at equal rates.
("The Roth is bigger" effect).

 

[Alan]

Bogie - if only the equation were that simple for all. Your example does not take into account the tax deductibility of a tIRA contrib. This came up a few months back: if the tIRA contrib is not deductible, and one pays the same tax rate before and after retirement, the Roth comes out far ahead due to its tax-free compounding.

I fully agree.

 

[GrayHare]

I guess I am thinking that the relative tax rates: conversion vs. withdrawal are still the largest factor in the conversion decision.

Agreed, kaneohe, it takes special/uncommon situations to outweigh the tax factor. You and I have posted about IRAs before, and I believe our conclusions are usually very similar.

 

[Bogie]

GrayHare,
My example assumes the tIRA was deductible.

And Alan, I was assuming the tIRA was deductible and I agree that the ROTH would be far an away better if it's not since the tIRA growth would be taxed. I was just trying to point out that for a deductible IRA vs ROTH it doesn't matter whether the tax is paid now or later if you assume the tIRA and ROTH get the same tax rate and earn the same return, you will have the same balance at the end after taxes are paid. Many people seem to think the tIRA is better because the pre-tax growth is compounded when actually it's tax is compounded as well. I didn't intend for tangential issues to be covered as those are individual experiences, YMMV.

 

[Alan]

GrayHare,
My example assumes the tIRA was deductible.

And Alan, I was assuming the tIRA was deductible and I agree that the ROTH would be far an away better if it's not since the tIRA growth would be taxed. I was just trying to point out that for a deductible IRA vs ROTH it doesn't matter whether the tax is paid now or later if you assume the tIRA and ROTH get the same tax rate and earn the same return, you will have the same balance at the end after taxes are paid. Many people seem to think the tIRA is better because the pre-tax growth is compounded when actually it's tax is compounded as well. I didn't intend for tangential issues to be covered as those are individual experiences, YMMV.

I agree.

When I ER'ed I had only a non-deductible IRA, as well as a large 401k. I held off rolling over the 401k until the following tax year to allow me to convert my IRA to a ROTH, paying taxes only on the gains of that IRA.

Now that the 401k is in an IRA with a zero cost basis, the arithmetic is quite different on doing conversions.

 

[nobodyknows]

I would not convert because the taxes would be too high.

 

[haha]

Unless we plan to spend retirement in poverty, given the fiscal pickle that the country is in I think most of us are likely best off paying some tax now and getting it done-at least down to a modest TIRA balance. It would be hard to paint Roth accounts as a millionaire trick, since high earners have been declared ineligible to participate.

Another thing, one can conceptualize a conversion in which you pay the conversion tax from your taxable account as a transfer of fully taxable portfolio money to Roth money. One would then have these balance sheet changes: y-x in TIRA, where Y was pre-conversion balance, and x is conversion amount; z+x in Roth, where z is pre-conversion amount, and S-a*x, where S is initial taxable balance, and a is marginal tax rate of all taxing authorities applied to transfer. So the total amount of tax deferred or tax free stays the same, just a shift from deferred to free, while the fully taxable account balance is decreased by the amount of the tax.


If one trades at all, the Roth balances should grow faster due to the tax drag on the taxable account.

Ha